Systemic liquidity risk and bipolar markets Wealth Management in Today’s Macro Risk On/Risk Off Financial Environment CLIVE M. CORCORAN Systemic Liquidity Risk and Bipolar Markets ForothertitlesintheWileyFinanceseries pleaseseewww.wiley.com/finance Systemic Liquidity Risk and Bipolar Markets Wealth Management in Today’s Macro Risk On/Risk Off Financial Environment Clive Corcoran A John Wiley & Sons, Ltd., Publication (cid:2)C 2013CliveCorcoran CoverimagereproducedbypermissionofShutterstock.com RegisteredOffice JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,WestSussex,PO198SQ,UnitedKingdom Fordetailsofourglobaleditorialoffices,forcustomerservicesandforinformationabouthowtoapplyfor permissiontoreusethecopyrightmaterialinthisbookpleaseseeourwebsiteatwww.wiley.com. TherightoftheauthortobeidentifiedastheauthorofthisworkhasbeenassertedinaccordancewiththeCopyright, DesignsandPatentsAct1988. Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmitted,inany formorbyanymeans,electronic,mechanical,photocopying,recordingorotherwise,exceptaspermittedbytheUK Copyright,DesignsandPatentsAct1988,withoutthepriorpermissionofthepublisher. Wileypublishesinavarietyofprintandelectronicformatsandbyprint-on-demand.Somematerialincludedwith standardprintversionsofthisbookmaynotbeincludedine-booksorinprint-on-demand.Ifthisbookrefersto mediasuchasaCDorDVDthatisnotincludedintheversionyoupurchased,youmaydownloadthismaterialat http://booksupport.wiley.com.FormoreinformationaboutWileyproducts,visitwww.wiley.com. Designationsusedbycompaniestodistinguishtheirproductsareoftenclaimedastrademarks.Allbrandnamesand productnamesusedinthisbookaretradenames,servicemarks,trademarksorregisteredtrademarksoftheir respectiveowners.Thepublisherisnotassociatedwithanyproductorvendormentionedinthisbook. LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbesteffortsinpreparing thisbook,theymakenorepresentationsorwarrantieswiththerespecttotheaccuracyorcompletenessofthe contentsofthisbookandspecificallydisclaimanyimpliedwarrantiesofmerchantabilityorfitnessforaparticular purpose.Itissoldontheunderstandingthatthepublisherisnotengagedinrenderingprofessionalservicesand neitherthepublishernortheauthorshallbeliablefordamagesarisingherefrom.Ifprofessionaladviceorother expertassistanceisrequired,theservicesofacompetentprofessionalshouldbesought. LibraryofCongressCataloging-in-PublicationData Corcoran,CliveM. Systemicliquidityriskandbipolarmarkets:wealthmanagementintodaysmacroriskon/riskofffinancial environment/CliveCorcoran. pagescm Includesindex. ISBN978-1-118-40933-6(hbk.)–ISBN978-1-118-41075-2(ebk.)–ISBN978-1-118-41076-9(ebk.)– ISBN978-1-118-41080-6(ebk.) 1.Finance,Personal. 2.Investments. 3.Portfoliomanagement. I.Title. HG179.C681972013 332.024–dc23 2012039741 AcataloguerecordforthisbookisavailablefromtheBritishLibrary. ISBN978-1-118-40933-6(hbk)ISBN978-1-118-41075-2(ebk) ISBN978-1-118-41076-9(ebk)ISBN978-1-118-41080-6(ebk) Setin10/12ptTimesbyAptara,Inc.,NewDelhi,India PrintedinGreatBritainbyCPIGroup(UK)Ltd,Croydon,CR04YY Contents Foreword ix 1 Introduction 1 1.1 HowHelpfulIstheNotionofTailRisk? 10 1.2 DichotomiesandAmbiguities 14 1.3 TrustandSolvencyAreAllorNothingDichotomies 14 1.4 TheAsymmetryofPrivateGainandPublicLosses 18 Endnotes 21 2 Cross-SectionalAssetCorrelations 27 2.1 LessonsforRiskManagement 35 2.2 CorrelationsandVolatility 36 2.3 IncreasedAssetCorrelations 42 2.4 StressRegressionAnalysis 45 2.5 HeatMapsIllustratetheBinaryNatureofRiskOn/RiskOff 49 Endnotes 57 3 TheChangingCharacterofFinancialMarkets 61 3.1 MarketReturnsDoExhibitMemory 66 3.2 HurstCoefficient 70 3.3 HurstValuesReachedExtremesDuring2008 72 Endnotes 75 4 TheFlashCrash 81 4.1 MarketMicrostructure 86 4.2 PredatorPreyDynamics 88 4.3 ComputerSimulationsofMarketBehavior 90 Endnotes 92 5 DetectingMiniBubbleswiththeVPINMetric 97 5.1 AdverseSelectionastheBasisfortheVPINMethod 98 5.2 TheRoleoftheJapaneseYenintheFlashCrash 110 Endnotes 116 vi Contents 6 ForeignExchangeandtheCarryTrade 119 6.1 PrimerontheForexMarket 120 6.2 TheFXCarryTrade 122 6.3 DoestheCarryTradePoseaRisktotheFinancialSystem? 123 Endnotes 129 7 TheEnigmaticPerformanceoftheJapaneseYen 133 7.1 TheNikkei225andtheYieldontheUSTreasuryTen-YearNote 137 Endnotes 146 8 TheAussie/YenConnection 149 8.1 TheRoleofAussie/YeninInter-MarketStrategies 157 Endnotes 162 9 PrecursorstoIlliquidity 165 9.1 UsingHeatMapsforFXandOtherAssetCorrelations 166 Endnotes 174 10 MainstreamFinancialEconomicsGropingTowardsaNewParadigm 175 10.1 DisappearanceofIncome 176 10.2 VendorFinancing 183 10.3 GlobalImbalancesandtheMartinWolfThesis 183 10.4 ProjectEvaluationandtheCostofCapital 186 10.5 TowardsaNewParadigminEconomicThinking 187 10.6 RationalandEfficientMarkets 190 Endnotes 194 11 CouldaEurozoneBreakupTriggerAnotherSystemicCrisis? 201 11.1 TheEuropeanStabilityMechanism(ESM) 209 11.2 ImpactofMonetaryUnion 211 11.3 TheDebtDeflationTrapintheEurozone 214 11.4 Eurobonds 218 11.5 TheVisceralDimensiontotheEurozone’sProblems 221 Endnotes 222 12 China,Commodities,andtheGlobalGrowthNarrative 227 12.1 ChineseConsumptionofBaseMetals 235 12.2 TheInternationalizationoftheRenminbi 243 Endnotes 246 13 DrawdownsandTailRiskManagement 251 13.1 ProtectingAgainstDrawdowns 260 13.2 TheTailRiskProtectionBusiness 265 13.3 RaisingCashandSwitchingtoSafeHavenAssets 267 13.4 ImplementingDrawdownProtectionStrategies 270 13.5 TailRiskProtectionfromOutrightFXPositions 273 Endnotes 279 Contents vii 14 LiquidityandMaturityTransformation 285 14.1 MoneyMarketSpreads 291 14.2 Liquidity 294 14.3 RepoFinancingastheSafestFormofIntervalConfidence 295 14.4 TowardsNewModelsofNetworkorSystemicRisk 298 14.5 TheShadowBankingSystemandLiquidityRisk 299 14.6 MaturityTransformationIsSpanninganInterval 299 Endnotes 302 15 EmotionalFinanceandIntervalConfidence 307 15.1 ConstructiveAmbiguity 308 15.2 DoubleBindsandEmotionalFinance 311 15.3 PatienceandInvestmentDecisionMaking 318 Endnotes 320 16 AdjustingtoMoreCorrelatedFinancialMarkets 327 16.1 SomeFinalMusingsonMarketsandMayhem 331 Endnotes 334 Appendix 337 Index 343